Good day, and welcome to the STERIS plc third quarter 2022 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing Star then zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press Star then one on a touch-tone phone. To withdraw your question, please press Star then two. Please also note that this event is being recorded. I would now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead.
Thank you, Matt, and good morning, everyone. Speaking on today's call as usual will be Michael Tokich, our Senior Vice President and CFO, and Daniel Carestio, our President and CEO. I do have just a few words of caution before we open for comments. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission, or rebroadcast of this call without the express written consent of STERIS is strictly prohibited. Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including, without limitation, those risk factors described in STERIS' securities filings. The company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments.
STERIS' SEC filings are available through the company and on our website. In addition, on today's call, non-GAAP financial measures, including adjusted earnings per diluted share, adjusted operating income, constant currency organic revenue growth, and free cash flow will be used. Additional information regarding these measures, including definitions, is available in today's release, including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the board of directors in their financial analysis and operational decision-making. With those cautions, I will hand the call over to Mike.
Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our third quarter performance. For the quarter, constant currency organic revenue increased 9%. Growth was driven by organic volume as well as 100 basis points of price. Acquisitions added $333 million to revenue, which is broken down by segment in the press release tables. To assist you with your modeling within the healthcare segment, of the approximately $210 million in acquired revenue, about 60% is consumable revenue from both Key and Cantel Medical. We passed the first year anniversary of the Key Surgical acquisition in mid-November, so this quarter, Key Surgical's revenue is split between organic and inorganic.
Gross margin for the quarter increased 90 basis points compared with the prior year to 45.1% as favorable productivity, pricing, and acquisitions were offset by higher material and labor costs. We continue to face increased material and labor costs, which totaled about $10 million in the quarter. As we look at the fourth quarter of the fiscal year, we expect increased pressure on material and labor of approximately $20 million, about twice as much as we anticipated just one quarter ago. For the full fiscal year, we anticipate absorbing approximately $45 million in unplanned material and labor costs, all while continuing to serve our customers and deliver a record year of performance. EBIT margin for the quarter was 24% of revenue, an increase of 40 basis points from the third quarter last year.
R&D expenses increased, and as anticipated, we are seeing operating expenses such as travel and sales and marketing costs return, somewhat limiting EBIT margin growth. The adjusted effective tax rate in the quarter was 21%, higher than last year, but in line with our expectations. We now expect the full year tax rate to be approximately 21.5%, reflecting year-to-date actuals and our expectations for the fourth quarter. Net income in the quarter increased to $213.3 million, and earnings per diluted share were $2.12. Our balance sheet continues to be a source of strength for the company. At the end of the quarter, cash totaled $359.1 million. We continue to focus on debt repayment, as evidenced by our leverage ratio at the end of the third quarter below 2.6x .
Year-to-date capital expenditures totaled $214.5 million, while depreciation and amortization totaled $319.3 million. Free cash flow for the first nine months was $300.3 million. As anticipated, this is the decline from the prior year due to costs associated with acquisitions and integration of the Cantel Medical acquisition and higher capital spending year-over-year. I will now turn the call over to Dan for his remarks.
Thanks, Mike, and thanks again to everyone for taking the time to join us today. Fiscal 2022 is shaping up to be another record year for STERIS. Our year-to-date results have been strong despite headwinds related to supply chain and inflation that are impacting both revenue and profit. In particular, growth in our AST segment remains very strong, with 21% constant currency organic growth year to date. Healthcare has also rebounded nicely, with 13% constant currency organic revenue growth in the first nine months and record backlog of $382 million at the end of the quarter.
Life sciences consumables have stabilized as anticipated and have contributed 5% constant currency organic revenue growth for the segment in the first nine months. The capital equipment backlog in life sciences has also continued to grow to a record $117 million. As our backlog in healthcare and life sciences suggests, the underlying demand for our products remains very strong. Dental revenue was about flat in the quarter, impacted by a slower than expected recovery in patient volumes. We do anticipate that revenue in the dental segment will begin to rebound in the fourth quarter. The integration of Cantel is progressing ahead of our expectations, as we indicated last quarter. We expect to exceed our cost synergy targets by about $10 million, and we are now approximately $35 million in total cost synergies in fiscal 2022.
Reflecting our strong performance to date, we are increasing our constant currency organic revenue outlook to the high end of our previous range and now anticipate approximately 11% growth for fiscal 2022. We are also increasing our earnings per diluted share outlook and now expect earnings to be in the range of $7.85-$7.95, or 10 cents above the high end of our prior outlook. We do have a few known headwinds in the fourth quarter. We completed the divestiture of our renal business, which will reduce both revenue by about $45 million and diluted EPS by about 5 cents in the quarter. In addition, we expect supply chain and inflation to be incrementally worse by about $10 million sequentially, as Mike discussed.
We do anticipate that we can offset some or all of those headwinds with higher cost synergies from the Cantel integration and continued operational improvements. However, we are leaving some room on the downside of our earnings range to reflect the continued uncertainty. All said, we are very pleased with where we stand today and the underlying strength of our diversified business. I want to thank all of the associates at STERIS for their hard work and continued dedication to serving our customers. We look forward to updating you all with our progress in the future. I'll now turn the call back over to Julie to open up for Q&A.
Thanks, Mike and Dan. Matt, if you give the instructions, we can get started on Q&A.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question will come from Matthew Mishan with KeyBanc. Please go ahead.
Hey, good morning, and congratulations on a really great year to date so far. My first question is on the progression of organic growth. If I'm modeling it correctly, I'm coming in somewhere in the fourth quarter around 5%, which would be a sequential deceleration. How should we be thinking about that in terms of the procedural environment? And then also, how should we be taking into account your ability to ship on the healthcare capital equipment backlog, given the, you know, really the massive number you have in orders versus maybe, you know, difficulty in supply chain in getting those out to customers?
Yeah, I think the issue on the 5% is that in the comps get tougher, you know, in terms of what we were looking at in Q4 of last year. We've also, you know, baked in what we believe is, you know, some slowdown that we saw in January and continuing into some of February in terms of procedures as it relates to Omicron, particularly across the U.S. We believe we've got that appropriately factored into our expectations. In terms of the capital equipment, I mean, we're, you know, at this point, we're almost halfway through the quarter. You know, we have in our model forecasted that we're providing, you know, an assumption that there's going to be some holdback of equipment that won't go just due to timing.
It's not an issue that we expect from an availability standpoint. It's more of an issue of, to some extent our customers appetite to receive that equipment within the quarter. Nonetheless, you know, I think what we stated before, there was about a somewhere around a $20 million increase in backlog that we would have attributed to deferral or, you know, supply chain issues and things of that nature. I don't think, Matt, that we'll flush that out this quarter. I think it would be unreasonable to expect that in the current environment, but we'll carry that backlog forward, you know, into the first quarter of next year.
Okay. Excellent. Then on to the operating margin. I mean, again, record operating margin in a difficult environment. How should we be thinking about the offsets you guys have had to the inflationary impacts? As I look at the corporate costs or the other costs as well as SG&A did come down significantly, you know, from 2Q into 3Q. Are those the Cantel synergies starting to be realized, and are they maybe coming in a little bit faster than they were previously, than you had previously thought?
Yeah, Matt, this is Mike. Yeah, we did anticipate that we are going to get more cost synergies, and you are exactly right. Those are going to show up first in the corporate side, as we have taken the opportunity to, you know, reduce the redundancy of the corporate costs, reduce the redundancy of the CEO, CFO. That's where you're actually seeing those cost synergy savings. As Dan spoke earlier, we anticipate overachieving those cost synergies in this fiscal year by about $10 million. Some of that has already been reflected through the third quarter. There'll be a couple single-digit million dollars that will still come through in the fourth quarter. All in all, you know, that is very favorable to us.
The other thing that we're seeing, and I think we're like everybody else, is, you know, our operating expenses have been bouncing around, especially around travel. We were anticipating more travel in the third quarter, which didn't happen, so you're seeing that little bit lower operating expenses in total.
Okay. There was nothing really transitory in those numbers that, you know, that would necessarily bounce back significantly into the fourth quarter, and we're sort of at a good run rate on some of those other costs.
Yeah, for the most part. I mean, the only variance that I would see being out there is, you know, our fourth quarter is the new year from a calendar year from a benefit standpoint, so you will see some, you know, some benefits costs that are normally higher. Year-over-year, those should be equal. Then the other thing is, you know, at the end of the day, where does the management bonus occur? And if there is an overachievement, obviously you will see that also reflected in the fourth quarter.
Understood. Thank you.
Yep, you're welcome, Matt.
Our next question will come from Chris Cooley with Stephens. Please go ahead.
Good morning, everyone, and congrats on a great quarter and what looks to be a great setup going into next fiscal year. I know it's a little bit early for the next fiscal year guide, but just maybe with broad strokes as we look at the business, you know, kind of following on Matt's initial question there, you know, capital, in particular in healthcare, really has stepped up over the last several years, and you do have a record backlog that you just alluded to won't pull through all the way here in the fiscal 4Q. Could you just help us think about kind of the end market there? Do we see a step up in the kind of baseline growth rate for healthcare capital going forward? Is that, you know, a function of replacement more efficiencies?
Is this something that we should really think about normalizing, kind of reverting back to those historic levels of growth, on the healthcare capital side as we get out sometime in mid-year by or at least by mid-year next, fiscal year? I've got a quick follow-up.
Sure, Chris. This is Dan. You know what I would say is there is some part of the backlog build that we're seeing now that's pent up demand on replacement, things that just didn't happen for at the same rate for six or nine months during the early, you know, first year or so of COVID. There is some element of that. However, what I would say is the capital spending we're seeing from large hospital systems, in particular across the U.S. and as well as surgery centers and things of that nature, is unprecedented right now. We're well positioned with a really strong portfolio of capital equipment in life sciences and then also in our surgical business and in our IPT business.
I think we're probably winning more than our fair share at this point in terms of our performance in the market. The market's very hot, and I don't know that I've ever seen this level of investment from our customers that we're seeing today. I don't see it slowing in the short term anyways.
Thank you. Appreciate that color. Then just kind of shifting gears to the life science segment. I continue to be impressed with the operating margin contribution that we see there as well as with AST. Can you just speak about, you know, thematically where you're seeing both of these portfolios product mix shifting towards? Really what I'm getting at here, you know, is this a stairstep where we're kind of flattening out at these record levels for a little bit, but as the mix continues to shift, you have a chance for another step up in margin?
Do we need to think about, you know, the operating margin contribution from here really becoming more a function of volume, through the plan expansion at the AST side as we just think about it thematically going forward? Thanks so much.
Yeah. I think in terms of AST, I would definitely point to volume. You know, we have a number of legacy older plants that are quite full that tend to contribute at the high end of margin in the portfolio. The newer plants as they come online are somewhat dilutive on a percentage basis. In aggregate with the total business, it doesn't really have a significant impact because there's been a steady diet of those plants coming on over the last, you know, few years. We would expect, with the exception of OpEx coming back, we would expect the margin rate in the AST business to hold pretty much.
In terms of the life science business, you know, the one caveat there is that there is some lumpiness to our capital shipments from quarter to quarter. The capital equipment business is generally at a lower margin than our service and our consumables business. You know, in whole, as we continue to grow consumables at a nice rate, that will have an impact on the overall margin of the business. However, if we keep taking orders in the capital side of the business like we have, I'm not sure that is gonna hold up.
Well, congrats again on the great quarter. Thank you.
Thank you.
Thanks, Chris.
Again, if you have a question, please press star then one. Our next question will come from Mike Matson with Needham & Company. Please go ahead.
Yeah, thanks. I wanna ask one about the renal care sale. We had estimated kind of $0.12-$0.13 of dilution on an annualized basis, but I think you called out about $0.05 in the fourth quarter. Does that imply it's more like a $0.20 number on an annualized basis? Can you just remind me what segment that falls or had fallen under previously, that revenue from that business?
Yeah, Mike, this is Mike. The majority of the revenue was falling under the healthcare side, so if you're gonna adjust the model going forward. There was a small piece that was in the life sciences business, but nothing really material. You know, as far as I've seen a couple different numbers. Is it $0.03? Is it $0.05? You know, some of this is IR math, if you will. You know, part of the issue is we are anticipating paying down debt in the fourth quarter with the proceeds. We did not get $190 million. A portion of that was held back in escrow. We did not pay down debt in Q1, Q2. It took us a while to clear the maturities that we had.
We had some 30 day maturities that we waited to pay down debt. There's some moving parts here. Again, our best guess is it's around $0.05. I wouldn't dramatically change for next year. If it's $0.04 or $0.042, who knows? But again, more IR math used here than anything. More directionally to give you an indication.
Okay.
If I might.
Yes.
Mike, the segment, the business is about half capital as you're doing your modeling.
Okay, got it. Just the really strong AST growth. I think in the past you'd had some kind of COVID benefit in there from PPE and things like that. I mean, was that a factor at all this quarter, or is this really just demand from your kind of normal, you know, medical device customers?
Yeah. It's demand from our normal med tech customers. The PPE is diminished back to, you know, pre-COVID levels or less than right now.
Okay. All right. Just finally, just given the strong, you know, backlog, great to see that, or I guess increase in backlog. You know, I'm wondering to what degree is that a function of the really strong orders that you're getting clearly, but, you know, is there some role for the supply chain issues there maybe limiting your ability? Like, could you meet this, you know, fulfill those orders more quickly if these supply chain issues weren't happening right now?
They would move a little quicker through the plants, but the percentage increase that we have in backlog is unreasonable to expect our factories to turn those at the same rate that we were six or nine months ago, you know, realistically. I think we said last quarter about $20 million of capital shipments were deferred because of supply chain issues, either on our end or on the customer's end of things. Like I said, I don't think we're gonna flush that through this quarter. It's gonna take some time for those things to work themselves out. You know, the other thing too is, you know, a lot of these orders, because a lot of it's long-term capital investment from, in particular the healthcare sector, you know, they're not asking for them to be delivered on March fifteenth necessarily.
There's time to get these built and delivered for customer need when they actually need to put them in place to get them operational.
Yeah. Okay. Got it. Thank you.
Our next question will come from David Turkaly with JMP Securities. Please go ahead.
Hey, good morning. Can you hear me all right?
Yep.
All right. Sorry, I'm in a bit of a spot. Mike, I think you said leverage was at 2.6, and obviously the last few deals you did have been very accretive, so I just wanted to get a comment on maybe your appetite here and where that leverage could go or can. What's your capacity right now to do deals like that?
As I mentioned, we have brought leverage down below 2.6 times at the end of Q3. Obviously, with the additional payment of about $170 million that we will put forward for the renal divestiture, obviously leverage will continue to drop lower than that by the end of the fiscal year. Right now, you know, we have the ability to, you know, more than one times from a leverage standpoint to do something from an M&A standpoint. As we've been saying all along, you know, the larger deals are few and far between. We will start getting back to more, I'll call tuck-ins, as.
Again, as everybody knows, we've been really more focused on the integration of both Key Surgical and Cantel Medical. The business development has been slowed at this point in time. We are getting back towards with leverage being below 2.5 at this point going forward. We are back to looking at opportunities to continue to grow the business, but more from a tuck-in standpoint as what you've seen in the past.
Thank you for that.
Our next question is a follow-up from Matthew Mishan with KeyBanc. Please go ahead.
Hey, great. Apologies if I missed it. I think previously you had reported FY 2022 numbers around like $4.6 billion. Is that number still relatively intact, or are we closer to, you know, $4.45 billion or $4.55 billion now with the divestiture?
Yeah, I would say, Matt, I would still use IR math and round up to 4.6.
Okay. On the inflationary impact into the fourth quarter, are you sort of reporting this on a lag basis where you buy inventory at a higher cost a couple of months ago, and then it starts coming through in January, February, March? Or are these the spot prices that you're seeing in the current market that could actually flow through into FY 2023?
No, this will be the actual amount we anticipate based upon the inventory turns and our various capitalization that we're talking about.
Is it something in which is getting better at least on a spot basis, where you see, you know, going out a couple more months, the prices are starting to come down? Should we think about this like $20 million level incrementally flowing through into next year?
Matt, this is Dan. It's too early to say. We have definitely seen spot prices for certain materials come down precipitously, and we've seen other ones where we have vendors not even willing to quote us cost three months out, you know, based on uncertainty on their end. Our hope is that we see it come down over the next three to six months, but I think we're gonna be living with some of these supply chain challenges for a while.
All right. Excellent. Thank you.
This concludes our question-and-answer session. I would like to turn the conference back over to Julie Winter for any closing remarks.
Thanks, everybody, for taking the time to join us this morning. We know it's a busy earnings season and look forward to catching up with many of you offline.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.